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Saturday, January 12, 2008

2007 was not a good year for the dollar. On a trade-weighted basis, the US currency lost about 7.5% of its value during the course of the year. According to the Fed’s trade-weighted Major Currency Index, the dollar was even weaker, losing about 10%. The dollar’s drop against its biggest rival, the euro, is also on a similar scale. Against the Canadian dollar, it plummeted even more, by over 14%, whereas against the yen, it only lost a modest 6%. The only currency against which the dollar managed on the whole to hold its ground was the pound sterling. Its significant loss of more than 7% evaporated within a few weeks towards the end of the year, when the Bank of England changed course practically overnight because of the Northern Rock disaster.

Pundits are divided about the dollar’s fate this year. Over the last few weeks, the idea that the US currency is now approaching its cyclical low has been gaining support. The arguments are as follows: the dollar has completed a six-year depreciation phase and, due to the outbreak of the credit crisis, the economic slowdown and the monetary policy turnaround in the US, it has now dropped so much that it is significantly undervalued.

Purchasing power parity is the main indication that the dollar might be undervalued: calculations show that purchasing power parity against the euro could be around 1.15 (with some degree of uncertainty). In addition, it is being pointed out that US price competitiveness has significantly improved, which is evident in the US trade balance. As a result of the substantial acceleration of US export growth during 2006 and 2007, the trade balance has stabilized. At over $587bn, the US foreign trade deficit in the period from January to October 2007 was more than $50bn lower than in the same period of the previous year, despite the negative effects of energy costs. And in three of the last four quarters, net exports made substantial positive contributions to growth.

Furthermore, in the last few months, when the extent of the credit crisis started to become clear, financial markets priced in massive interest rate cuts by the Fed. Currently Fed Funds Futures are pricing in a 50 basis point interest rate cut to 3.75% for the end of January, and further cuts to 2.75% by the end of 2008. The yield curve, and thus presumably the foreign exchange rates too, have already priced in the assumption that the US economic situation will deteriorate considerably. In that case, there would be little chance of market participants being disappointed.

According to an old stock market rule, “when bullets fly, stocks are a buy”. Given the dreadful news about a number of banks’ asset writedowns and the increased risk of recession in the US, some think that this time has now come for the dollar. At any rate, even Gisele Bündchen, Brazilian top model who had reportedly shunned the dollar, has now confirmed that she is still happy to be paid in the US currency.

However, we advise caution, at least for those market participants whose investment horizon does not stretch over years. In our view, the crisis is not yet over, in fact the worst is still to come. Up to now, the US housing market and credit crisis has manifested itself mainly in an increasein asset writedowns and in liquidity problems. But there has not yet been much evidence of the real economic consequences of these developments.

In our opinion, the fundamental problem, which is crucial for further macroeconomic development, is that banks will have to tighten new lending sharply, as they do not have the necessary capital to extend lending activities. The impending asset writedowns are having a negative effect on capital or are forcing banks to procure fresh funds at a very high price, reducing profitability. In previous years, the problem could have been mitigated by shifting the financing process to the capital market. But after the recent experiences with securitized structures, there is only limited scope to do so. On the contrary: to maintain the overall level of financing, banks would have to give out more money to make up for the fact that less funds can be raised through the capital markets. Furthermore, banks’ own capital requirements will increase as customers’ ratings will tend to deteriorate and because of the new Basel II regulations.

The macroeconomic situation in the US (and in Europe) has been quite favourable up to now. GDP growth was strong up until the third quarter, and growth will probably still have been halfway moderate in the fourth quarter too. The employment level still remains high, and incomes are rising substantially. We fear, however, that the credit squeeze will spill more and more into the real economic sector during the coming months.

In our view, it is unlikely that the dollar will be able to withstand the impact of more and more bad news, in spite of priced-in growth concerns. This will apply particularly if equity markets should lose their tenacity. Moreover, the dollar’s interest rate disadvantage against the euro will increase rapidly, if the Fed cuts interest rates at the expected pace, and the ECB remains basically hawkish. We therefore expect EUR-USD to hit fresh highs again in the first half of 2008.